Warren Buffett’s always-anticipated annual letter was released last weekend. It was shorter than I expected. I’m not surprised either.
Buffett’s older letters are better, more specific about his thought process, and more educational for dedicated investors. His more recent letters are almost the opposite – more general in nature, certainly more PC, yet still educational but for a broader, arguably less savvy, shareholder base.
The section over the last few years on “The Bet” is a good example of this. We all pay attention to what something costs. But usually, that’s the last thing a new investor thinks about when picking which funds to own (lack of fee transparency doesn’t help). Once it’s explained that high fees hurt returns, most people get it.
Performance comes, performance goes. Fees never falter.
The people that don’t get it, more than likely don’t care because they believe paying more brings status, prestige, or bragging rights. In most cases, it’s just a waste of money.
Of course, the shareholder base changed significantly with the ’09 BNSF buyout, with the 50-for-1 BRK class B stock split. The stock split made it easier for fans to buy the Buffett & Berkshire experience at a significantly lower introductory price – about $3,000 pre-split to about $60 after.
His letter’s over the past several years reflect that shift. That said, there are still some things to take away — some solid reminders, at least — from this year’s short letter.
New Accounting Rules
Buffett kicked the letter off with the new accounting rules. New GAAP rules, regarding unrealized capital gains and losses, will directly impact net income for any company that holds securities. That means any movement in those stock prices, affects net income whether BRK sells any shares or not.
The new rule says that the net change in unrealized investment gains and losses in stocks we hold must be included in all net income figures we report to you. That requirement will produce some truly wild and capricious swings in our GAAP bottom-line.
The market regularly freaks out over unexpected earnings numbers. That won’t change. The market often takes a surface view of earnings numbers, without digging deeper for the cause(s) behind the results.
The new accounting rules might have a bigger impact on the initial perception of those surface numbers. This should be a great opportunity for those willing to do more legwork (than the market) into any company that holds stocks.
Price Still Matters
The list of things Buffett looks for in a company haven’t changed. Neither has the importance of price. Though lately, price seems to be ignored by many:
In our search for new stand-alone businesses, the key qualities we seek are durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and, finally, a sensible purchase price.
That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.
Put simply, it’s harder to earn a good return on your money by paying any price. When the market is filled with people willing to do just that, it’s best not to follow their lead.
In the meantime, we will stick with our simple guideline: The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.
Downside of Leverage
Leverage can be useful. But like a lot of useful things, too much of it can be harmful. History is filled with examples of disastrous outcomes from the overindulgence of debt.
Our aversion to leverage has dampened our returns over the years. But Charlie and I sleep well. Both of us believe it is insane to risk what you have and need in order to obtain what you don’t need. We held this view 50 years ago when we each ran an investment partnership, funded by a few friends and relatives who trusted us. We also hold it today after a million or so “partners” have joined us at Berkshire.
This is especially true when using margin debt. Investing on margin can enhance returns in both directions. Margin trading might seem like the brilliant thing to do when prices are rising but the randomness of prices in the short term – the market “voting machine” – can be costly.
Stocks surge and swoon, seemingly untethered to any year-to-year buildup in their underlying value. Over time, however, Ben Graham’s oft-quoted maxim proves true: “In the short run, the market is a voting machine; in the long run, however, it becomes a weighing machine.”
Berkshire, itself, provides some vivid examples of how price randomness in the short term can obscure long-term growth in value. For the last 53 years, the company has built value by reinvesting its earnings and letting compound interest work its magic. Year by year, we have moved forward. Yet Berkshire shares have suffered four truly major dips. Here are the gory details:
This table offers the strongest argument I can muster against ever using borrowed money to own stocks. There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.
This is even more important when you consider the next lesson. It’s impossible to seize opportunities when you’re wiped out by debt.
The market “voting machine” mentality continuously presents opportunities in the short run.
You don’t need a unique insight or the highest IQ. Sometimes all it takes is to be a better-behaved investor in a crazy market.
When major declines occur, however, they offer extraordinary opportunities to those who are not handicapped by debt. That’s the time to heed these lines from Kipling’s If:
“If you can keep your head when all about you are losing theirs . . .
If you can wait and not be tired by waiting . . .
If you can think – and not make thoughts your aim . . .
If you can trust yourself when all men doubt you…
Yours is the Earth and everything that’s in it.”
Though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon such as alpha and beta. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period – or even to look foolish – is also essential.
All the different definitions of risk can be confusing. I believe the two that matter most are a permanent loss of capital and loss of purchasing power. Big losses are very hard to recover from, but not being able to buy the stuff you need tomorrow, that you can today is just as bad.
Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. “Risk” is the possibility that this objective won’t be attained.
By that standard, purportedly “risk-free” long-term bonds in 2012 were a far riskier investment than a long-term investment in common stocks. At that time, even a 1% annual rate of inflation between 2012 and 2017 would have decreased the purchasing-power of the government bond that Protégé and I sold.
I want to quickly acknowledge that in any upcoming day, week or even year, stocks will be riskier – far riskier – than short-term U.S. bonds. As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates.
It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment “risk” by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk.
We’re taught bonds are the “safe” portion of our portfolio. At a time when interest rates were the lowest in history, many investors held too large a portion of their portfolio in bonds. It’s difficult to meet financial goals when the rate of return on high-grade bonds is no higher than inflation. It’s equally hard to do it by paying too high a price for stocks.
Investing is filled with rules of thumb that work…most of the time. However, the rules don’t work all the time, especially when you deal with periods historically out of the norm.
The one thing you can hang your hat on is:
- Markets are constantly changing. Nothing lasts forever.
- Some portion of the market will always overindulge on the belief that current conditions will go on forever.
- Most good things, taken to excess, are harmful.
- Everything in investing is a trade-off: stocks or bonds, domestic or international, action or inaction.
Stick with big, “easy” decisions and eschew activity.